Hedging In Commodity Trading, Protecting Your Position
Here we take a look at the activity of hedging in commodity trading, and why participants use this approach to protect their business.
Those who sell or buy physical commodities use the commodity futures markets for protection.
The idea is to protect their trading position in the event of commodity prices moving adversely against them.
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So, for example, a producer of high grade copper may want to be sure that when the copper is delivered in say three months time, they will get today’s price for the metal which is high.
As the copper market is always moving, with copper prices rising or falling, there is no certainty of getting the right price.
So the copper producer would sell copper futures and make a profit on the futures contract to offset the lower price he will receive when the metal is delivered.
Or let’s say there is a company called Chiltern Oil, which has a small onshore oil field discovery in the UK, a great find in these times of ever higher crude oil prices, with 100,000 barrels of crude to be sold.
Chiltern Oil wants to make sure its light, sweet crude oil fetches a good price in 8 months time.
Today the company could get around $110 a barrel, but if the world economy slows and the benchmark NYMEX WTI crude oil futures heads south over the next eight months, the price may only be say $80. Chiltern can sell its 100,000 barrels of crude on NYMEX for $110 and then relax and carry on with business as usual, without worrying that the price may fall over the coming months.
When the time comes to deliver the oil in the market, the price has fallen to $78 a barrel, which is lower revenue for the company.
But now they can liquidate their futures contract which has increased in value and so offset the reduced revenue from the physical sale with profits on the paper contract.
This method of protecting the profits when a producer sells a commodity into a market where the price is falling is called a Short Hedge.
In other words a way of managing risk or exposure to volatile markets and price spikes or collapses.
When end users protect their input costs
Let’s look at it from the perspective of a commercial end-user, such as a food manufacturer or in our example, a factory called Chocolotta Limited which makes chocolate.
Chocolotta Limited gets the bulk of its important ingredient cocoa from Ivory Coast in Africa, a region which can be subject to civil unrest.
The company needs more cocoa in five months time but it needs certainty about how much to pay for the new supplies.
Today, in July, the price is $1,650 per ton of cocoa but who knows what it will be 5 months out.
Chocolotta decides to buy 5 December futures contracts at $1,700 a ton, and as each contract is for 10 tons, the total futures contract is for $85,000.
Even if there is serious civil disorder in Ivory Coast which sends cocoa prices up to $2,000 per ton, Chocolotta will make gains on its cocoa futures which will offset the higher input costs.
This is how futures contracts offer a valuable way of protecting end-users from volatile and unforeseen price movements. So when a company buys a futures contract in this way it is referred to as a Long Hedge.
When you are trading commodities as a speculator looking to make some profit, just consider that out there in the market there will be producers and sellers looking to hedge their position, in effect to avoid losses.
Commodity Futures Margin
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